"The negative outlook reflects concerns about the weakening fiscal consolidation effort and the unfavorable trends evident in the country's debt profile," S & P said Friday.
"The rising share of external debt, estimated at about 49 percent of the total, and, within that, the proportion of more expensive and shorter maturity commercial funds, is gradually eroding what has so far been a relatively favorable debt profile."
"Moreover, the apparent modest improvement in the debt ratio is due largely to a monetary policy stance, whereby negative real interest rates allow the financing of large fiscal deficits without a significant corresponding rise in public debt as a share of GDP."
S&P confirmed Sri Lanka's underlying 'B+' foreign currency and 'BB-' local currency ratings.
The rating agency said the outlook could be lifted to stable if budgets improved and money printing was reduced.
S&P said it was looking for evidence "meaningful deficit reduction" and reducing the pace of "monetization of deficits" (money printing) fueled inflation in the island.
Persistently high inflation, now more than 20 percent a year against a background of high government and private sector credit called for a "for more forceful policy actions to restore price stability."
But if budget deteriorated further from rising expenses or lower revenues, or government borrowing became worse, S& P warned that the rating itself could be downgraded.
S & P said revenue growth has slowed 19.5 percent which was below the estimated nominal gross domestic product (GDP) growth rate (real GDP growth and inflation).
"At the same time, current expenditures, notably defense and interest service, have been higher than planned, with total spending growth exceeding revenue growth," the rating agency said.
"These developments appear to have reversed the tentative positive momentum in the fiscal trajectory that was generated by earlier revenue and expenditure improvements."
Last year S&P lifted the outlook to 'stable' from 'negative' citing improvements on the fiscal side.
But S&P is now saying that an "ambitious revenue forecast and an "optimistic" economic growth assumption in the 2008 budget may cause an overshooting of a 7 percent of GDP planned deficit.
"Given these changes, the prospects for a fundamental turnaround in Sri Lanka's fiscal trajectory substantially diminished, at least for the time being."
S&P said "vague deficit reduction targets" and lack of commitment pointed to a "defining priority" towards fiscally driven growth, maintaining subsidies and meeting military objectives.
The rating agency said this policy stance increased the risks from a debt ratio that was already well above the average national debt of countries rated as 'B+'.
Sri Lanka's national debt is above 85 percent of GDP but has come down from 100 percent levels three years ago.
"Political conditions, including recent developments in the war with Tamil separatists, continue to weigh on Sri Lanka's rating," S & P said.
"The official end of the ceasefire and the LTTE's (Liberation Tigers of Tamil Eelam separatists) stepped up attacks on civilians in response to government military gains make peaceful resolution a more distant prospect.
"The escalating conflict increases risks to the economy and the risk of reduced donor support..